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Real estate is one of the most popular investments for self-directed IRA (SDIRA) owners seeking to diversify their retirement portfolios and maximize their savings.
However, with great opportunity comes the responsibility to adhere to specific IRS rules and regulations. Failure to comply with these rules can result in severe penalties, including the disqualification of your IRA.
To make the most of your SDIRA real estate investments and avoid these pitfalls, here are some essential rules to follow when investing in real estate with an SDIRA.
The IRS strictly prohibits certain transactions involving SDIRA assets to avoid conflicts of interest and ensure the integrity of the retirement account.
Key prohibited transactions include:
All income generated from the property (e.g., rental income) must go directly into the SDIRA. Similarly, all expenses related to the property (e.g., maintenance, property taxes, insurance) must be paid from the SDIRA. Using personal funds to pay for expenses or depositing income into a personal account can result in prohibited transactions.
When renting out a property owned by your self-directed IRA, remember to inform tenants that checks must be made directly to the IRA, and NOT to you, personally. Accepting checks addressed to you, instead of your retirement account, could trigger a prohibited transaction.
Here is an example of the correct way for tenants to address a rent check:
To: The Entrust Group, Inc. FBO [Your Name] [Your Account Number]
If you don’t have the requisite funds to make a direct real estate purchase, there are two primary options that can increase your SDIRA’s purchasing power:
You can partner your SDIRA with other investors, including other IRAs, other investors, or even your personal funds.
One question we often get is, “Why can my IRA partner with disqualified persons?”
Your IRA can partner with disqualified persons for new investment transactions because these partnerships do not involve direct buying or selling between your IRA and a disqualified person. Instead, it involves pooling resources to jointly purchase a new property, which is considered a separate and independent transaction by the IRS.
You can also partner your funds again for future purchases. Each new purchase is considered a separate transaction, allowing you to reinvest jointly without breaching IRS rules.
However, once you establish a partnership, you must avoid any prohibited transactions with disqualified persons. This means no buying, selling, or exchanging assets between the SDIRA and disqualified persons, and no personal use of the jointly owned property.
In this arrangement, each partner owns a percentage of the property based on their contribution. All income and expenses are divided according to ownership percentages.
Here’s an example,
If you’re applying for an investment property with your personal funds but don’t have the requisite funds, you can apply for a mortgage. Generally, lenders want a 10-20% down payment, as long as you have a good credit history.
But what if you want to take out a loan with your IRA? Well, your IRA doesn’t have a credit history, and the IRS prohibits IRA holders from extending their personal credit history to their IRA.
So, are you out of luck? Not quite.
Instead, you can take out a non-recourse loan. This type of real estate loan is secured by nothing but the property being purchased. Therefore, the lender’s only recourse in the event of default is to seize the collateral. The lender cannot go after the borrower’s other assets.
5 Steps to investing in Real Estate with an SDIRA. Get your free copy now >
If your SDIRA invests in real estate that leverages debt financing (such as a non-recourse loan), a portion of the property’s income will be subject to unrelated business income tax (UBIT).
For example, let’s say your IRA purchases a condo for $500,000. However, your IRA only holds $300,000. Your IRA is approved for a non-recourse loan to cover the other $200,000.
However, whatever portion of property is financed by debt must pay UBIT. So, if your IRA rents out the condo at $3,000 a month, then $1,200 would be subject to UBIT at trust tax rates.
Of course, this percentage would gradually decrease as your IRA pays off the non-recourse loan. The quicker you pay off the loan, the quicker you can lower your tax liability.
All property purchased by the SDIRA must be titled in the name of the SDIRA, not in your personal name.
Typically, the correct titling format is, "The Entrust Group, Inc. FBO [Your Name] [Your Account Number]."
This ensures the property is legally owned by the IRA and not by you personally.
Each year, you must report the fair market value of your SDIRA assets to the IRS. This involves obtaining a current, accurate valuation of the real estate held in the IRA. The valuation should be done by a qualified, independent appraiser and submitted to Entrust by January 31.
Starting at age 73 (as of current regulations), you must begin taking required minimum distributions (RMDs) from your traditional SDIRA.
Real estate investments can complicate RMDs due to their illiquid nature, so it's important to plan how you will meet RMD requirements without having to sell the property at an inopportune time.
There are three primary distribution strategies to help manage RMDs in this situation:
The simplest method is to maintain a cash reserve within the SDIRA by allocating rental income or other sources of cash flow to cover future RMDs. This approach requires advance planning to ensure sufficient liquidity.
You can take an in-kind distribution by transferring a portion of the property ownership from the SDIRA to yourself personally. The value of the distributed portion counts towards your RMD.
For example, if your RMD is $40,000 and the property is valued at $400,000, you could transfer a 10% ownership interest in the property from the SDIRA to yourself.
Note: Even if your personal funds own 10% of the property, you still cannot use the property for personal use. As long as your SDIRA owns any portion of the asset, the property is still subject to prohibited transaction rules.
Lastly, you can sell a portion of the real estate property to meet the RMD requirements. This involves subdividing the property or selling an undivided interest.
For instance, if your RMD is $50,000 and your property is worth $500,000, you could sell a 10% interest in the property to meet the RMD requirement.
By following these rules and working closely with a knowledgeable SDIRA provider, you can effectively manage real estate investments within your retirement account while avoiding costly penalties.
Want to learn more about the process of real estate investing inside an SDIRA? Download our guide, 5 Steps to Investing in Real Estate with an SDIRA. You’ll find a list of the different types of properties your IRA can invest in, how to fund your IRA for the purchase, and the key IRS rules to be aware of.
If you have more questions about the investment process, reach out to one of our SDIRA experts. They’ll be able to give you the information you need to decide if this type of investment account is right for you.
Finally, if you’re considering which real estate sectors are poised for growth in 2024, watch a replay of our webinar with the “Mad Scientist of Multifamily”, Neal Bawa. During the detailed session, Neal walked us through the top disruptive real estate trends he forecasts for 2024 and beyond.